When you expect a moderate increase in a stock or ETF price, perhaps options trading is the right approach for you. The bull call spread strategy involves buying one call option and selling another at a higher strike price. This call debit spread limits losses while capping gains, making it ideal for moderately bullish markets. Let us look at the key elements of this strategy with the theory behind this spread and a real-life example.
Key takeaways
- A bull call spread is an options strategy used by traders who expect a moderate increase in an asset’s price.
- This bull call spread strategy employs two call options: one purchased at a lower strike price and another sold at a higher strike price, creating a defined range.
- As a debit spread, it limits potential losses while also capping potential gains, making it ideal for investors with a moderately bullish outlook on the underlying stock.
What Is the Bull Call Spread Strategy?
First of all, we should start by defining the bull call spread strategy. This is a vertical spread involving two call options with the same expiration date but different strike prices. The bull call spread strategy requires an initial debit, hence it’s also known as a call debit spread. The primary purpose of this setup is to reduce the upfront cost compared to buying a single call option while capping both potential gains and losses.
Description of the Strategy
- Definition: The bull call spread strategy involves purchasing a call option at a lower strike price and selling another call option at a higher strike price within the same expiration period.
- Initial Debit: This strategy requires an upfront payment, making it a call debit spread. The net premium paid to establish the position represents the initial cost.
How to Build a Bull Call Spread
- Buying a Lower Strike Call: This is the long call component of the bull call spread strategy, which benefits from an increase in the underlying asset’s price.
- Selling a Higher Strike Call: This is the short call component, which helps to offset the initial cost of the long call but caps the upside potential.
By buying a call at a lower strike price and selling another at a higher strike price, the trader reduces the upfront cost. This makes the strategy more affordable compared to purchasing a single call option outright.
Profit/Loss Dynamics
- Maximum Gain: The maximum gain is capped at the difference between the strike prices minus the net premium paid. For example, if you buy a 60 strike call and sell a 65 strike call, the maximum gain is $5 (65-60) minus the net premium paid.
- Maximum Loss: The maximum loss is limited to the net premium paid. If the stock price is below the lower strike price at expiration, both call options expire worthless.
- Breakeven Point: The bull call spread strategy breaks even if the stock price at expiration equals the lower strike price plus the net premium paid.
Bull Call Spread Payoff – What Does Your P&L Look Like?
This is the profit & loss (P&L) profile of a typical bull call spread:
Specifically, this is the P&L you would obtain from the following trade:
- Scenario: Suppose a trader buys a call option with a $50 strike price for $3 per share and sells another call option with a $55 strike price for $2 per share on a stock currently trading at $50.
- Net Premium Paid: $1 per share ($3 – $2).
- Maximum Gain: $4 per share or $400 in total for each contract (difference between strike prices minus the net premium paid).
- Breakeven Point: $51 (lower strike price plus net premium paid).
A Bull Call Spread Example
Let us take a look at Tesla (TSLA) to better explain the bull call spread strategy. TSLA is currently trading at $232.07, and you spot an opportunity using our options screener. Specifically, here is what you could do:
- Buying the Lower Strike Call: Purchase a $220 call option.
- Selling the Higher Strike Call: Sell a $225 call option.
- Expiration: Both options expire in two days.
The P&L profile of your bull call spread strategy would look like this:
Trading options with very short expiration is inherently risky. You should be prepared for the worst-case scenario where the stock does not perform as expected. In any case, here is what the P&L profile above tells you:
- Breakeven Point: $224.45. This is calculated by adding the net premium paid to the lower strike price.
- Maximum Bull Call Spread Loss: $445 if TSLA falls below $220. This loss occurs because both your bought and sold call options would expire worthless, meaning you’d lose the initial debit paid.
- Maximum Bull Call Spread Payoff: $55 if TSLA remains above $225. This profit is the difference between the strike prices minus the net premium paid, yielding a 12.36% profit ratio.
While a 12.36% profit ratio might seem modest, you consider the probability of TSLA falling by more than 3% in two days to be low. This leads us to a deeper reasoning: why would you pick this trade?
Why This Trade?
Despite the risks, let’s say you have reasons to be optimistic about this trade:
- Market Reaction to Earnings Report: You believe that the market’s reaction to TSLA’s recent earnings report has settled, and a more calm period lies ahead.
- Market Trends: The “Magnificent 7” stocks have been declining, suggesting the market might attempt to move upward for a few days.
- Moderate Bullish Outlook: You are mildly bullish on TSLA, expecting a small price increase but not a major rally.
In fact, you should always have reasons that go beyond pure speculation to justify a trade. The three points above are just an example, as every trader is different.
Historical Price Context
Examining TSLA’s historical price chart is also essential. Take a look at the chart below:
The $225 price level appears to be a significant support/resistance point. Buyers and sellers seem to agree on this pricing level at the moment, suggesting it may hold in the short term.
Some Additional Considerations
There are a couple of things you should consider concerning the trade, and this bull call spread example on TSLA gives us the right occasion to underline two points:
- Assignment Risk: There is a risk of early assignment, especially if TSLA’s price exceeds the strike price of the short call. This means you could be forced to sell the underlying asset at the strike price before the expiration date. However, since you hold a bought call, your PL profile will stay the same (you can’t lose or earn more than the initial calculation).
- Expiration Risk: Holding the options into expiration adds another layer of risk. You won’t know until the following Monday whether the short call was assigned or expired worthless.
How Do Price, Volatility and Time Impact Your Bull Call Spread Trade?
So far (thanks to TSLA’s bull call spread example above), we have mainly talked about the impact of an underlying price change on the bull call spread strategy. Now, let’s spend a few words to recap how price, volatility, and time affect this strategy, as summarized in the table below:
Price Impact
- Profit Potential: The bull call spread strategy profits if the stock price rises but is capped by the short call’s strike price.
- Maximum Profit: Achieved when the stock price is at or above the higher strike price at expiration. For instance, if you buy a $220 call and sell a $225 call, your maximum profit occurs if the stock price is $225 or higher at expiration.
- Moderate Gains: If the stock price is between the strike prices of the long and short calls at expiration, your profit will be lower than the maximum you could achieve (the same goes for your loss, depending on whether you are below or above the breakeven price).
- Loss Scenario: If the stock price falls or does not rise sufficiently, the bull call spread strategy incurs a loss limited to the net premium paid. For example, if TSLA falls below $220, your maximum loss is the initial debit paid for entering the trade.
Volatility Impact
The bull call spread features a near-zero vega, meaning that the effects of volatility changes on the long and short calls often offset each other. While the strategy is generally neutral to volatility changes, extreme stock price movements can lead to one option being more affected than the other.
Typically, when volatility rises, the prices of both the long and short call options tend to increase, neutralizing the overall effect. However, it’s important to note that the strategy isn’t completely immune to volatility changes; the overall impact depends on factors such as the moneyness of the options and the time remaining until expiration.
Time Decay (Theta)
Time decay has a significant impact on both the long and short calls in a bull call spread. As expiration approaches, the long call loses value, which is detrimental to the overall strategy. On the other hand, the short call gains value as it nears expiration, potentially offsetting the negative effects of time decay on the long call.
An important distinction to note is that while the bull call spread is a debit strategy, there are also credit strategies like the bull put spread strategy. In a bull put spread, traders receive a net premium upfront by selling a put at a higher strike price and buying a put at a lower strike price. This strategy allows investors to profit from time decay while maintaining limited risk exposure, making it ideal for bullish market conditions with minimal upfront cost.
One of the key advantages of the bull call spread strategy is that it experiences less time decay compared to a long call. This occurs because the time decay on the short call helps to mitigate some of the decay experienced by the long call.
Additionally, the position of the stock price plays a crucial role in the strategy’s performance. If the stock price is near or below the lower strike price, the strategy will incur losses over time. Conversely, if the stock price is near or above the higher strike price, the strategy will increase in value as time progresses.
While we’ve discussed the impact of price changes, it’s important to consider alternative strategies that adjust for different market scenarios. One such strategy is the covered put strategy, which is ideal for investors who hold a moderately bearish outlook and want to generate income while managing downside risk.
Advantages and Disadvantages of Using a Bull Call Spread Strategy
After seeing the theory behind the bull call spread strategy and a real-market example, we can summarize the main pros and cons in the table below:
Advantages
- Limited Risk: The bull call spread strategy comes with a clearly defined potential loss, which is limited to the net premium paid to establish the spread. This makes it a safer option compared to other strategies that might have unlimited risk.
- Lower Upfront Capital: This strategy requires a lower initial investment compared to buying a single long call option. By selling a call option at a higher strike price, the trader receives a premium that offsets the cost of the purchased call option, reducing the net outlay.
- Suitable for Moderately Bullish Outlooks: The bull call spread is ideal for investors who expect a moderate rise in the stock price but want to limit their risk exposure. It allows them to profit from a moderate increase without taking on excessive risk.
- Profit Potential: Although the bull call spread payoff is capped, this strategy still offers a reasonable return if the underlying asset’s price rises to the level of the short call’s strike price. For example, a bull call spread example could show the potential gains if the stock price moves favorably within the specified range.
Disadvantages
- Limited Profit Potential: One of the main drawbacks is that the profit potential is capped. The maximum profit is limited to the difference between the strike prices of the two call options, minus the net premium paid. This cap on gains can be a significant limitation for traders looking for higher returns.
- Negative Impact of Time Decay: Time decay (theta) negatively impacts the bull call spread strategy. As time passes, the value of the long call option decreases, which can erode potential profits. Although the short call option’s time decay works in favor of the trader, it may not fully offset the loss from the long call.
- Early Assignment Risk: There is a risk of early assignment, especially around ex-dividend dates or corporate events. If the short call option is assigned early, the trader may need to sell the underlying asset at the short call’s strike price, which could result in a loss.
- Expiration Risk: If the stock price is near the short call’s strike price at expiration, the trader faces expiration risk. The position may need to be adjusted or closed to avoid unwanted outcomes.
